Relevant Costs and Marginal Costing Example

Numerico a garage have calculated that for every hour it works the marginal cost is £15 per hour. The charge out rate is £40 per hour and its fixed costs are £700 per week. If Numerico does 40 hours of work in a week the situation is as follows:

  • Total contribution: 40 hours @ (£40-£15) £1,000
  • Less: fixed costs 700
  • Weekly profit 300

As we can see from the above each worked hour contributes £25 towards meeting our fixed costs, working a 40-hour week earns us a profit of £300. We can use the relationship of contribution and fixed costs to examine our break-even situation, an issue that we return to later.

Management Decisions

Being able to identify and understand marginal costs and contribution helps us to use with a variety of decisions, such as:

  • Product or service evaluation
  • Make-or-buy decisions
  • Break-even analysis

Product or service evaluation
One of the primary objectives in selling our products or services is to make a profit, though a conscious or unavoidable decision may be made to make different levels of profit (or loss) for each product or service. It is helpful in our decisions on product mix to know what the relative contributions of our products or services are.

Adding or de-listing products or services
Matching up our contribution from our products or services against their fixed costs shows us the ‘individual’ contributions earnt. If we know what the individual contributions are then our decisions on product mix can be more effective.

There are a number of factors contributing to business survival and prosperity, being responsive to our market place is one of them. Knowing the present or future contributions from our products or services helps us to maintain, develop or de-list them.

Make-or-buy
As with most decisions financial information plays an important part, make or buy decisions are no exception. Make-or-buy decisions extend to:

  • Manufacture or buy from a supplier
  • Doing something ourselves or hiring another company to do it

The comparison of the cost of each alternative can be based on its marginal costs, plus any additionally incurred fixed costs. We should ignore any costs which are unaffected by our decisions (current fixed costs), since they are not really relevant.

Break-even
This is the point at which our total contribution equals our total fixed costs – nil profit, nil loss. If we know the ‘unit’ contribution then we can out what we have to sell to break-even. This can be illustrated by reference to our garage example above.

  • Weekly fixed costs 700
  • Contribution per hour 25
  • No. of hours to break-even (£700/£25) 28
  • Check: 28 hours × £25 per hour 700

Every hour that Numerico works above 28 will be the net profit, fixed costs having already been covered. Another useful piece of information is the margin of safety.

Margin of safety
This is the difference between our break-even point and our normal level of activity. If we use the example of Numerico, assuming a worked 40 hour week.

  • Total revenue: 40 hours × £40 per hour 1,600
  • Break-even point 700
  • Margin of safety £300
  • Margin of safety (% of sales) 18.75%

Knowledge of break-even can help us in to evaluate the present, the future and what-if situations.